D. Trump takes office; the UK, the ECB and China stay the course

Macro Highlights
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1/25/2017

China met its 2016 GDP growth target at the cost of increased debt levels. The next question mark is how D. Trump intends to handle China-US trade relations. UK financial institutions should lose the EU financial services passport, while an accelerating Eurozone inflation should not lead the ECB to change course.

In the United States, expectations were high in the run-up to D. Trump’s inauguration speech. Many investors came away from it with an equally strong sense of disappointment. This is reflected in the subsequent decline in the dollar and in 10-year Treasury yields. The speech provided little insight into the new president’s priorities, but it did show that D. Trump has not changed his guiding line since he was elected on 8 November 2016. He came off as assertive, delivering a strong pitch for his policy agenda and emphasising that every action he takes will be aimed at bolstering GDP growth and creating jobs in his country.

In recent weeks, D. Trump’s policy agenda got a boost from two other factors:

His choice of cabinet members appears to be consistent with the positions he staked out during the campaign. The people he chose for a number of key posts in his administration are fuelling the hopes of those Americans who favour deregulation in the financial and oil industries, a restriction on illegal immigration and job creation in the US manufacturing sector. That said, only two appointees were confirmed by the Senate on D. Trump's first day in office (versus seven on B. Obama's first day): J. Mattis, as Secretary of Defense, and J. Kelly, as Secretary of Homeland Security. These two individuals have met with the least resistance in the Senate committees so far.

His message was reinforced by his first executive order, targeting Obamacare. The order does not repeal B. Obama’s health insurance law, but it does introduce flexibility in how it is applied, giving Federal agencies the ability to grant more exemptions. In reality, the order may be more symbolic than anything, but it shows how determined D. Trump is to act quickly and pragmatically. This same pragmatism is apparent in his plans to meet with the president of Mexico and the prime minister of Canada in order to renegotiate the North American Free Trade Agreement.

We sense that investors’ expectations are still too high, and this could weigh further on both the dollar and short-term interest rates. We expect GDP growth to accelerate, but our forecast is below the consensus estimate: 1. despite its recent slide, the dollar has risen since the summer of 2016, and this could hurt US exports in the first half of 2017, 2. higher interest rates could also prevent residential investment from expanding too quickly early in the year.

In China, Q4 GDP growth reached 6.8%. This puts the full-year figure at 6.7%, which is in line with the official target. This slightly stronger growth rate is a result of government stimulus measures, which also served to exacerbate the country’s economic imbalances. Unbridled lending in China has pushed debt to 264% of GDP, versus 247% at the end of 2015. Beijing has now turned its attention to the United States and is awaiting details on D. Trump’s plans for China-US trade relations. The uncertainty generated by a tough protectionist stance in the United States would make it harder for China to resolve its structural imbalances. China’s reliance on exports declined from 37% of GDP in 2006 to 22% in 2015. But international trade is still a key piece of the puzzle for China. Any disruption by Uncle Sam on that front – through tariffs or damaging taxes (e.g. a border adjustment tax) – would probably cause the country to miss its official GDP growth target. It could also lead to reprisals from China, which could go so far as to devalue the yuan.

UK Prime Minister T. May clarified her government’s priorities as she positions the country to leave the European Union (EU). She stated that her main objective is to regain control over her country's borders with the EU, and she noted that the UK would no longer fall under the jurisdiction of the European Court of Justice. She acknowledged that, accordingly, the UK could not remain a member of the EU’s single market once it has left the Union. The UK could also leave the customs union, which would allow it to negotiate trade deals with non-EU countries.

These statements are in line with T. May’s stance in October. The prime minister attempted to soften her tone by showing support for a transition period and saying that the outcome of negotiations with the EU would be submitted to the British parliament. This does not change the fact that the UK government has opted for a hard exit, with little room for negotiations with the EU.

Analysis and implications:

T. May made clear her desire for new free trade deals with the EU. But that won’t happen without the support of European countries. The UK’s departure from the single market makes it more likely that UK financial institutions will lose the financial services passport and that clearing houses will have to move to the Euro zone, as we expected.

On 24 January, Britain’s Supreme Court will announce its decision on whether the government needs parliamentary approval to trigger Article 50 of the Lisbon Treaty. This is crucial. If parliament must have its say, then T. May may not be able to kick off the negotiations in March 2017 as announced.

We still believe that the question marks surrounding the terms of the UK’s departure from the EU will continue to weigh on the pound over the next few months. We are maintaining our end-2017 GBP/USD forecast of 1.15.

Turning to the Euro zone, as we expected, the European Central Bank (ECB) left its monetary policy unchanged at its 19 January meeting. At the post-meeting press conference, M. Draghi defended the ECB’s monetary policy despite the recent rise in Euro zone inflation (year-on-year inflation rose from 0.6% in November to 1.1% in December). He argued that there was no “convincing upward trend” in core inflation (0.9% in December). He also confirmed that there was no significant disagreement within the Governing Council, pointing out that all members thought that the December decision to extend quantitative easing was the right move at the right time. He mentioned that this move “succeeded in preserving the very favourable financing conditions”.

Analysis and implications:

M. Draghi’s emphasis on the low level of core inflation should limit upward pressure on Euro zone yields. He is basically implying that the ECB has no plans to reduce its monthly asset purchases to below EUR 60 billion between April and December 2017 despite an ongoing increase in total inflation. We still expect the ECB to adhere to its asset-purchase programme throughout 2017. In our view, the size of the monthly purchases will not be reduced before 2018.

M. Draghi's comment that the December decision preserved “very favourable financing conditions” showed that one of the ECB’s goals was to disconnect European rates from US rates. We are maintaining our 2017 forecast for the 10-year Bund yield at an average of 0.34%.